Ituran Location and Control Ltd (ITRN) 2006 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Ituran Limited third quarter 2006 results conference call. All participants are at present in a listen-only mode. Following management's formal presentation, instructions will be given for the question and answer session. As a reminder, this conference is being recorded November 21, 2006.

I would like to remind everyone that the conference call may contain projections or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions and may change as time passes. Ituran does not assume any obligation to update such information. Actual events or results may differ materially from those projected, resulting from changing industry and market trends, reduced demand for the company's products, the timely development of the company's new products and their adoption by the market, increased competition in the industry and price reductions, as well as risks identified in the documents files by the company with the SEC.

You should have all received by now the company's press release. If you have not received it, please call Gelbart Kahanaat 1-866-704-6710.

I will now hand over the call to Mr. Ehud Helft of Gelbart Kahana. Mr. Helft, would you like to begin?

Yes, thank you. Good morning and good afternoon to everybody. I would like to thank Ituran management for hosting this conference call to discuss the third quarter 2006 results. With me on the call today are Mr. Eyal Sheratzky, Co-CEO, Mr. Eli Kramer, CFO of Ituran, and Mr. Udi Mizrahi, VP Finance.

Eyal, would you like to begin, please.

Yes, thank you Ehud. Welcome everyone, and thank you for joining us today. Our third quarter results continued on our long stretch of improving revenues, net income and profitability. Our revenue grow 14% over those of last year. But more significantly, net income grow 35%. Our record net margin again demonstrating the strong operating leverage inherent in our business. This is in accordance with our subscription business model, which means that every new customer on the available infrastructure with almost no additional cost bring a higher contribution to the profit.

In our core subscription business, we maintain our trend of continually increasing our customer base. Our total customer base grew by 20% over last year. In South Korea, we were awarded a 14.6 million order for the second and third phase of the deployment of our infrastructure agreement to our local customer in Korea. The system will enable this Korean service provider to deliver location-based services for people, cargo and cars with full coverage South Korea.

We signed a contract to acquire ERM. Even though this is a small acquisition, we see strong synergies and growth potential in ERM. And I will elaborate about it later on.

Overall, we are very pleased with the results and the direction in which the company is progressing. I do believe that the positive results and the continued improvement that we have been showing over the last couple of years will continue for the rest of this year and beyond.

Now I will hand over to Eli for the financial. Eli please.

Thank you Eyal. As for the financials, revenue for the third quarter of 2006 reached $26 million. This represents a 13.5% increase compared with revenues of $23 million in the third quarter of last year. The increase in revenue was driven by the continued growth of the company's subscriber base as well as sales of the company's infrastructure in the Far East and in the AMR products.

Revenues breakdown for the quarter was $13.8 million coming from subscription fees from our location-based services, which show a year-over-year growth of 21.8% and $12.2 million coming from product sales which shows year-over-year growth of 5.3%. The geographic breakdown of revenues in the quarter was as follows. Israel 38%, United States 19%, Argentina 7%, Far East projects 10%, Brazil 26%, with Sao Paolo accounting for the majority of that. Our new venture in Rio is progressing as planned. But contribution to the overall numbers is still small.

In terms of subscriber numbers, we reached a total of 383,000 at the end of the third quarter of 2006 compared with 320,000 at the end of third quarter 2005, a growth of 19.1%. When compared with the end of the previous quarter, our net growth in subscribers was 8,000.

During the third quarter, one of the customers in Brazil determined that they would discontinue the service with few thousand members in Brazil in order to cut costs. In terms of the effect on the business, this had a relatively small impact due to the fact that these particular subscribers were among our lowest-paying subscribers. Also, it is worth noting that our gross subscriber additions were [strongest] this quarter and actually stronger than our gross additions in the second quarter. Gross margin in the quarter was 48.7%, and for the third quarter of 2005 was 48.6%.

Operating margins for the quarter were 24.1% compared with an operating margin of 21.9% in the third quarter of 2005. Net profit was $4.9 million in the third quarter of 2006 representing a growth of 35.4% over the $3.6 million reported for the third quarter of 2005. Fully diluted EPS in the third quarter of 2006 was $0.21 compared with $0.19 per fully diluted share in the third quarter of 2005.

Following our initial public offering on the NASDAQ towards the end of last year, the number of shares grew from 19.1 million in the third quarter of 2005 to 23.4 million in the third quarter of 2006. Cash flow from operations during the third quarter of 2006 was $5.6 million. As of September 30, 2006, the company had a net cash position, including marketable securities, of $57.3 million compared with $2 million on the September 30, 2005. Following the end of the quarter, the board of directors approved a $10 million share buyback. To date, Ituran has purchased 60,000 shares totaling $0.9 million.

I now hand back to Eyal. Eyal?

Thank you Eli. I would like to talk now about our potential acquisition of ERM, a manufacturer of the leading-edge vehicular alarm and GPRS tracking system. Our acquisition of the controlling share in ERM represents an important step in our overall strategy to become the leading global company in the vehicle tracking and security space. It adds a number of cutting-edge security and tracking solutions to our existing product portfolio. We see the ERM business as an additional future growth engine for Ituran. And we expect to have a progress in this acquisition in the next few months.

As part of our growth strategy, we are constantly examining M&A opportunities. And I myself devote a large portion of my time toward it. However, we are committed to doing such deals only if they make strong business and financial sense. And I hope that we will be able to announce a further deal during 2007. Looking back over the year, 2006 has been a strong year. I do believe that we will continue to grow our business over this year and beyond, maintaining double-digit growth in our top line in 2007 with a higher growth rate in our net profit due to the leverage in our business model.

With that, I would like to turn over the call to Q&A. Operator please.

Thank you, sir. [OPERATOR INSTRUCTIONS]

The first question is from Maynard Um of UBS. Please go ahead, sir.

All right. Thank you. I was hoping if you could talk a little bit more about that one customer who was doing some cost-cutting. And in your discussions with your other customers whether they remain committed. And also if you would expect the level of net sub adds to remain at that 15 to 20,000 as we move forward into the next quarter and following. And then I have a follow-up question.

Hi Maynard, good morning.

Good morning.

First, the growth was actually strong. But the net growth was relatively due to this fact that you mentioned that one of our largest clients decided to release a few thousand subscribers from our service. This is due to the fact it was not economic for them to keep them as our subscribers -- I mean to keep the end users. A situation like this, Maynard, this is unusual, but can happen in our business. We don't have a specific material customer. We have many hundreds of thousands of customers. And one of them, which is in Brazil, it can happen. For us, it did not make sense to further reduce the fees for these subscribers. And the client calculated it for this particular customer, it didn't make economic sense to maintain these subscribers who are also [derived] from our ARPU as well.

I would like to stress that this is not a long-term trend. And while such things can happen in normal course of business, we don't think that this will have an impact on our business beyond one or two quarters. Furthermore, these subscribers were our lowest paying subscribers so that the impact on our top and bottom line is minimum.

Okay. So in terms of the following quarters, the 15 to 20,000 would be a reasonable run rate going forward?

As I've said, the relationship with this customer that results with some big churn, I would say, this quarter to be more conservative. There is some additional churn that I at least for conservative reason want to expect for coming one or one and a half quarters. I think or I assume that, based on the database that we have, it will be lower than Q3 but have some impact. Actually, if you are talking about 2007, add to this the Rio de Janeiro potential, I think that the number that you mentioned is achievable. It makes sense. And this situation will not influence us next year.

Okay. And just to be clear then, the gross adds, though, will continue to be pretty strong. It's just that the churn that -- from this one customer that will be impacted.

Exactly. Without providing numbers, because we didn't do it up until now, just to give you as a phrase, we had more customers this quarter than Q2 of this year. And one of the highest growth of total subscribers in our life. But the churn create this issue.

Okay. And then a follow-up question on the gross margins for both segments. They look like they were lower sequentially. Can you just talk about the gross margins and how we should view that going forward?

First of all, regarding subscribers, Udi will talk about the sales part -- regard service side, as you remember from last quarter, when we started the Rio operation, it's appeared this quarter a little bit more strongly that we had to have some of the expenses. This is beginning of the operation, only second quarter of commercial operations. We're still in the level that we have to have some of the expenses, to have some expenses. So this is keep us with some gross margin of about -- on the consolidated numbers -- of about 65.5, almost 66%. Actually to look forward and back to a year ago, I think that, on an annual level, still this year will be stronger in terms of gross margin and it will continue to grow next year as well.

The current quarters are almost flat, I would say, basically because of the influence of Rio.

Okay. And on the wireless communications side? Is that just mix?

On the mixture of the product side, it was first of all higher than the past -- a little bit lower, but really not material, less than 1% lower than Q2. And for the future, if you are talking about this year, again for conservative reasons, I would say that Q3 in terms of margins is representing the next quarter probably in terms of margins. Next year, again based on our leverage model of operation, I think, believe and expect that the margins will go up from the gross margin to the bottom line.

Okay great. I'll get back in the queue. Thank you.

Thank you.

Thank you. The next question is from [Amy Nunn] of JP Morgan. Please go ahead.

Hi. Good morning. It's Amy Nunn for Paul Coster. Eyal, I was hoping you could talk a little bit about the ERM acquisition a bit more in terms of what technologies specifically attracted you to this company; what if any plans you have in terms of integrating their product offering with what Ituran provides currently? And then I have a follow-up question.

ERM, one of the -- not of the reasons -- but one of the things that creates us a lot of confidence regard this company is about 10 years of a mutual operation; meaning they are our supplier of security systems, which are less related to the location side of the -- for the location technology. But if you remember Ituran, one of the most important models of providing our services is [inaudible]. And when we integrated security systems to our DTOA technology, it was done by ERM.

During the last two years, ERM entered also to a GPS and cellular solution for [wide] services, such we deal with. And since we are finding ourselves in some events, specifically in Brazil and Argentina and in the U.S., that we are dealing with a GPS system all for fleet management, all for added-value services, which will allow us to go out of our specific coverage area, we saw that our quantities that we are continuing [still] buying from ERM is growing. And on the other hand, the request for this kind of services from us is growing as well. And based on an understanding that we need additional technology on our shelf in order to provide customers whatever they need.

Because customers, when we are service provider, our customer's looking for a service. They're looking for the application. They're not always looking for the technology itself. So when you are talking about car theft in Sao Paolo, of course the [video] technology is the best. And when you are talking about concierge services, fleet management, and sometimes roadside assistance out of the coverage area, we have to have the ability to send the customer with a service, to have the customer with a contract. And ERM has a superior technology as we understood after many years of working together. And we decide that this is a strategic acquisition although it's not a big one.

All right. And then on China, can you give us an update as to developments there, since I think the last news flow we heard from you was around the last [season] orders. So have there been any updates there? And also with regard to your AMR business, what's the status of that?

China -- I will start with the AMR. The AMR is growing this year more than we expected. We are not providing numbers -- public knowledge about what is the contribution. But this sector in Ituran is growing this year more than 35% growth rate. And we can say conservatively that this trend should continue and 2006 was or still represents a big growth in the AMR.

We are continue to sell our units to [ARA] through Master Meter. And Master Meter succeed to expand its market share in U.S. and to offer new generation of AMR for water to the same utilities and to expand its customer base. And based on that, we succeed. If you remember, we published the 20th, we did 310,000 units in 2005. As I said, to be conservative, I'm expecting at least 35 or even more than that gross numbers of product, and of course, in the revenue side for AMR.

On the China project, we found some delays that are not based on our products, our infrastructure. Basically it seems we are almost in the end of building the infrastructure in Beijing and Shanghai, now we are more dependent on the commercial operation of the Beijing operator and the Shanghai operator. They had some several internal issues and problems, which are not related anything to the business results -- something among the shareholders internally there -- some things about pilot project that they want to win and the wait.

Actually this delayed the Chinese project as might be you expected as myself as well. But on the other hand, in terms of continue and making the contract and the progress as is so they're still as is. We are waiting now for them to start launching and start recruiting subscribers beside the first phase that they are in, meaning now as they are showing us they are going to some decision makers to make promotion and to provide the first order that they start buying from us some thousands of units to show it, and to market it, and to create the market.

I believe and I hope that if their commercial, meaning marketing and sales efforts, and their business plan will be as they are clear and say to us, so we expect that the operation in China will take off next year.

Okay great. And then finally with regards to Brazil and I guess kind of Latin America generally, have you seen any changes in the competitive landscape there, pricing pressures or other competitive changes during the last quarter?

First of all, Amy and everybody, to be with almost 400,000 subscribers, diversified between many customers, in a market which we are not the only player, we always have to struggle to make as more money as we can. Always there is a struggling. Always there is competitive landscape. Still, our technology, our brand and our distribution channel, specifically in Brazil, Argentina, are stronger than the others.

And I wouldn't say that we feel today or through Q3, different pressure than we had two years ago or a year ago. Always the customer want to pay less. Always we want to accept more. Nothing changed. The specific events with our client in Brazil is not related to any difference in the total market or in the trend in Brazil. This is specific customer with specific needs that was not satisfied with the price or with the negotiations that they had with us and he decide to take out some of his customers. And some of his customers will continue to use the technology. So actually, this is the situation.

All right. Thank you.

You're welcome.

The next question is from [Jan Freeman] of [Bank Poland]. Please go ahead.

Good evening gentlemen. I would like to start with a question about the background of your revenues and the subscribers number.

I didn't understand the question.

I would like to ask the breakdown of your revenues and subscriber numbers among the [continents].

We are not providing any quarterly -- because of, of course, commercial and competitive landscape we are not provide it on a quarterly results, only on the [20th].

Okay. What about the revenues? You gave it before, but I didn't hear it.

What other revenues?

We're talking about the service revenue. We're talking in the third quarter of '06, geographical breakdown you mean?

Yes

Okay. The geographical breakdown is follows. Israel is 38%; USA 19%; Argentina 7%; Far East Project 10%; and Brazil 26%.

Okay. Thank you. And the last question is about Rio de Janeiro. How many subscribers do you have there?

We still not have a material numbers. We have few hundreds. But the trend seems to be as we expected. Don't forget that this is the second quarter only that we are operating commercially. We have to promote the system. Actually, it's as we expected. But it's not a material number yet. It's few hundreds per month.

Thank you very much.

The next question is from Jim McIlree of Unterberg, Towbin. Please go ahead.

Thank you. What do you expect your capital spending to be in Q4?

Actually, there is no any difference than the past besides Q1 and 2 that we had --

In Q3, we are talking about the capital is about a little bit more than $4 million. In that amount, there is the building that we purchased in Brazil. [Part of] let's say a part of the amount that we purchased was paid in the third quarter -- a part of it in the second, and a part of it in the third quarter. In Q4, we are talking about our estimation is, let's say, between 2 to $3 million.

Okay. And have you delivered all of the equipment to South Korea for the phase one of that project? Or is there still more to be delivered?

To Korea, phase one, we delivered majority of the infrastructure.

When is the rest of it complete? Is it this year? Or does it go into next year also?

Phase one -- I would say that it's finalized already. A small portion of it will be realized in Q4. But the phase two and three -- to complete the answer, the majority of phase two and three will be in 2007.

Okay. Does that start in Q1? Or does that start sometime in the middle of the year?

You mean phase two and three?

Yes.

It has already started. As we have said, we are expecting that, among the $14.6 million project, about 15 to 20% will be realized this year. We started in Q3. We'll continue in Q4. But the majority, which is close to $12 million, will be realized only next year.

Right. Thank you very much.

You're welcome.

The next question is from [Jonathan Ho] of William Blair. Please go ahead.

Hello?

Hello.

Hey guys. Just a quick question on the ARPU. It seems to have increased sequentially. Other than the effect of maybe the drop-off of these lower-paying customers, was there anything else that might have played a role in that sequential increase in the ARPU?

No actually, the differences are -- if you compare it to last quarter -- is about $0.10 per customer. Since the number of customers is big, so it has a material influence of course. Actually we succeed to show it increase [constantly], basically because of the mixture of the customers. But I'm saying that, in terms of $0.10 or $0.20 up or down in the ARPU, we can find some volatility. And this would -- I must say, is a conservative reason, because there is some volatility of $0.10, $0.20 in the ARPU.

But overall, in talking on a more longer term, year-over-year, or two years over two years, we succeed based on different segments and different penetration to high price the segments to increase our ARPU. And I hope and I want, and we are spend a lot of effort that it will continue by offering added-value services, by increase our penetration to the private market, to the uninsured population for example. Up until now, we succeed to do it.

Great. Can you talk a little bit more about this private market that you guys are going after and some of the trends that you're seeing there?

Yes. Actually we do it almost two years now. Until two years ago, we didn't attach these segments. It was and is much faster or much easier to work only through insurance companies. But we understood that the market in Brazil has a material number of potential market which are uninsured population in Brazil. More than 40% of the people do not insure their car.

And we came with a model which required us to increase our marketing and sales in Brazil toward this segment, toward this population. And on the other hand, our brand, which is quite [inaudible - background noise] in Sao Paolo, as well as our relationship with insurance brokers that are facing, that are approaching those kind of customers by selling them, for example, health insurance or houses insurance, and offer them something which is not related to the premium. We succeed to use this distribution channel as well by providing them fees and promotion stuff. And it seems that, today, we start seeing material portion of the new customers comes from the uninsured population.

Okay. Thanks guys.

You're welcome.

The next question is from Andrew Spinola of Needham & Company. Please go ahead.

Thanks. Related to the uninsured subscribers, last quarter you had mentioned that the costs for the hardware there are -- come through CapEx, and then I guess hit the income statement through depreciation. Is that becoming a more meaningful amount of your CapEx? Is that at all the reason why it was so much higher this quarter, and could stay higher going forward?

Okay. First of all, I didn't -- probably there was a misunderstanding. I talked about a way which we call -- or it's done in Spanish is [comondato], meaning leasing solution that I said that if you will see, or you already saw, some different classification of the revenues from sending hardware to the balance sheet side with additional revenues on the service side. So this is [inaudible - background noise] this quarter. It didn't -- as we expected. But it didn't take off. It didn't become more stronger; which means, there wasn't a material change compared to the past way that we show it in our P&L.

On the other hand, the CapEx aspect between Q2 and Q3 was mainly because of the -- compared to the other CapEx in the past, is basically because of acquiring a facility in Brazil instead of continue renting it. As we expect from next quarter and ahead, our CapEx showed be reduced, unless -- and here I'm saying something that if we will find that it's more economic for the company to acquire the facility that we are using than to rent based on economic calculations, might be that this occurrence will happen again. But we are here talking about the core CapEx, it's not actually a very material change. And it will continue to be between 2 to $2.5 million.

Got it. Thanks. Just trying to understand the subscriber net sub adds in the quarter. You said that you had record -- well not record. I'm sorry. You had higher gross adds than you did in the second quarter. And you lost 2,000, from this one Brazilian customer, potentially a few more, in the fourth quarter. But it looks like, obviously, net sub adds were 9,000 lower in the third quarter versus the second quarter. So I'm guessing there's 7, 8,000 higher churn in the third quarter than the second quarter. So the actual rate of churn was much higher. Can you explain that?

Actually I think that my accent wasn't good enough. I didn't say 2. I said few thousand. Again --

Okay.

From commercial reasons, because of other competitors of this client, we didn't want to put the exact numbers. But the number is higher than 2,000.

Fair enough. Okay, and then it looks like, I guess, Argentina was 10% of rev in the second quarter, 7% of rev this quarter. So it's down, it looks, almost 20, 25% sequentially. Anything happening there? Has the business slowed?

Andrew, I think that as we mentioned in the past, in the product sales segment, there could be a volatility due to the inventory level that dealers and insurance companies manage by themselves. In this matter, I can tell you that, for example in Argentina, we received an order for the end units in the beginning of October, meaning that there was just a shifting between the quarters.

Great. That's helpful. Thank you very much guys.

Thank you.

The next question is from Roni Biron of Oscar Gruss. Please go ahead.

Hi guys. I have a question on the product gross margin. Shouldn't it have gone up as more revenues are coming from your turnkey projects and AMR business? Is it related to the inventory changes you just indicated or anything else?

One minute, Roni. I just want to understand the question. One minute.

You want me to repeat the question?

Actually the mixture changed, but it's not changed only for the good side, which is the Far East. There was also other sales. For example, the RFID, which we had a decline in Q3, compared to Q2, which is represent a high gross margin. And this is an influence on the let's say on the bad side. So actually the average was stayed the same as Q2.

Okay. And in regard to your turnkey project in Korea, do you have any initial indications as to the pickup of the service in the area, in Seoul for example, where they're already launched a service. How aggressive the operator is in terms of pushing the service forward and so on?

No, they are not using Seoul. They call it a soft launch. And they are only promoted for the next phase two and three. They are not operate Seoul on a full coverage. And this is something that we knew was expected, because our customer in Korea is determined. And this is why he has decided to spend more than $20 million and much more than that in local investment to cover all South Korea. Their model and their strategy is to cover the whole country and start provide a nationwide service cell.

Of course, we will start the selling around Seoul. But this mainly will be for promotion reasons. And we see that we are selling them units based on their order, which is currently few hundreds per month. And it seems that they succeed. And they have declined to use it. But we are not expecting that, before mid-next year, South Korea will represent tens of thousands of units only for sale.

Okay. And in regard to your manufacturing process, have you made any adjustment to cope with the scope of the follow-on order from Korea?

Yes. Part of our plan, together with the Korean customer, is to start manufacture the base station [for] phase two and three in South Korea. We are in middle of identifying the right vendor to make it. In terms of end units, we are not yet in this level, because we have the right facility to maintain the orders. But as you can see in our inventory side, since we are expecting growing of sales to South Korea, we are buying additional inventory that, at least at the first orders, we will react faster.

Okay. A final question for me -- in regard to ERM, have you completed, and when do you expect to complete, the acquisition? Is it sometime in the fourth quarter?

Actually, we are depend on the one regulation approval, which is the antitrust. And as long as our lawyers are telling us, it should be in the fourth quarter. But since we have only additional one month for the fourth quarter, to the worst case scenario, it will come in the first quarter of next year.

Okay, thank you.

Thank you.

Next, we have a follow-up from Maynard Um of UBS. Please go ahead.

Hello? Hello?

Hello Maynard. Are you there?

Hello?

Yes.

Can you hear me? Okay, sorry. I think you answered my question on inventories. But in terms of the tax rate, is there a material change depending upon the mix in the business? Or, as we look out into next year, will we see a big variance from the 25% level that we're seeing currently? Thanks.

Maynard, if we are talking about the tax rate as we mentioned in the second quarter, that this year for example, '06, on an annual basis will be around 25, 26%, meaning that the next quarter will be on the range of between, let's say, 26 to 28%. And this is because of using NOLs that we had, or that we have. And next year, our estimation for tax rates is between the 28 to 30% on an annual basis.

Great, thank you.

Thank you. [OPERATOR INSTRUCTIONS]

There are no further questions at this time. Mr. Sheratzky, would you like to make your concluding statements?

I just want to say again, as we've said last quarter, that I'm happy with the results. I think that the results match our expectations. We are showing that a double-digit growth is something that we was expected. And probably, with the additional one quarter for this year, we will succeed to show and to maintain it. And I would like to thank everybody for their attention and of course for the questions. Have a good day. Thank you very much.

Bye bye.

Thank you. This concludes Ituran Limited third quarter 2006 results conference call. Thank you for your participation. You may go ahead and disconnect.